Government's Money-Manipulating Wizardry

Explaining the mechanics of Federal Reserve operations.

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There's great debate about inflation versus deflation. Most who are buying stocks aren't doing so because they see good fundamentals, but are doing so because they're worried about inflation. Clearly the Federal Reserve is doing "unconventional" things (perhaps I should use better words such as crazy and irresponsible) which have a lot of people worried about a crashing dollar.In order to clarify my position, I want to describe to you some mechanics of Federal Reserve operations, the wizardry behind the curtain. I recommend you send this to all of your friends so they can decide for themselves. This is long and tedious, but I think worth it.

The Federal Reserve is a private bank, albeit special. It has shareholders that care about profits and risk. These aren't normal shareholders, but other banks or the boards of those banks. The Fed was given certain powers by Congress in 1913 to regulate the money supply of the US. That benign-sounding statement has vast implications on capitalism and liberty itself.

Capital can be loosely defined as wealth, unencumbered assets of various forms like cars, buildings, manufacturing plants, and land. Capital is created through productive processes that lower costs, develop new technologies, and raise living standards.

An example of a productive process might be one of specialization. Two farmers grow their own food, make their own clothes and cut down their own firewood. It takes each 15 hours a day to do all this work. They realize one has better land and the other one makes better clothes so they barter to exchange goods. This bartering results in each working only 12 hours a day. One farmer can then take the extra time and sew more clothes and thus barter it with another farmer for more firewood. The extra clothes can be described as "capital" that can be used to raise living standards. Capital can only be created through the production process.

In today's world, non-liquid wealth in the form of hard assets can be converted into something called money. Money is merely a medium of exchanging hard assets. Money is the liquid form of wealth in only this sense: it is a store of wealth only based on this exchange value. You can't eat or drink or live in money. Hard assets have a price in dollars to convert them to liquid money.

There's always a defined amount of wealth at any one time in the world, as created by productive processes that increase living standards. This is the real pool of savings. The more production, the more wealth is created. This is a very important statement as you will see later.

Capital can be lent to a borrower. Someone with capital would forgo its use in the present to generate a return. Normally capital is converted to money to be lent. The price of money is an interest rate, how much one charges to use the money.

It makes sense that only those with capital can lend it. Someone can borrow capital from someone else and then lend it to another, but it all starts with the person with capital.

The first red flag is this then: A government, which has no capital of its own, which produces nothing on its own, cannot lend money unless it borrows that capital from another or takes that capital in the form of taxes (but taxpayers must have capital to pay taxes).

The Fed controls interest rates (to a certain extent in normal situations; to a large extent in special situations) to influence the demand and supply of money. Again this innocuous-sounding statement has vast implications. Here is how it works:

There are times in an economy when those with capital don't want to lend it. It almost always is a time when they see too much risk for too little return.

If we have too many condos in Florida those with capital say I don't want to lend money to build more condos because there is too high a risk that they won't sell and I won't get my money back. So they raise the price of money; they raise the interest rate they charge to compensate for too much risk.

This is how an economy naturally controls itself. It's called capitalism: the allocation of capital based on risk and return.

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